Time For Change?

As the U.S. Federal Reserve lowered interest rates by a quarter percentage point this week, a number of countries in the Middle East followed suit. Specifically, countries such as Saudi Arabia, the United Arab Emirates, Qatar, Kuwait and Bahrain adhered to the Fed’s decision, because their currencies are pegged to the dollar. This is undoubtedly the case for most of the Persian Gulf nations that are now facing severe inflation. “The combination of soaring oil prices and the tumbling dollar is distorting their economies and fuelling inflation,” according to the latest print edition of the Economist.

These concerns over inflation in all of the oil-rich states suggest that central banks should in fact be raising, not lowering rates. However, “monetary policy in the Persian Gulf states must mirror U.S. moves to avoid pressures from capital drifting to the currency with the most favorable interest rates” (Critchlow) .Consequently, economists believe that with enough pressure the Gulf states may soon break free from the dollar.

In fact, in September Saudi Arabia decided not to lower interest rates in tandem with the U.S. Federal Reserve (Gaffen). One only has to look so far to notice that the entire Gulf region is diversifying away from the dollar. This phenomenon is particularly true, because of the increasing number of oil exports at extraordinary prices. Further, with plenty of money flowing into these states’ coffers, pegging their currency to a depreciating currency is becoming less and less attractive.

Thus, the question arises: Should the region’s economies continue to tie their currency to the greenback? The original purpose for doing so was due to the financial immaturity of these states and lack of monetary experience. Determining the right interest rates to most optimally match a country’s savings with investments is tricky due to a typical central bank’s contrary goals of fighting inflation while creating economic growth.

The fact of the matter is that due to the Gulf Arabs soaring oil revenues, “their real exchange rates ought to rise” (“The dollar | Time to break free”). The peg to the dollar prevents this and as the value of the dollar falls, inflation has become a larger problem. Today, the U.S. inflation rate hovers around 4 to 5 percent on average since the economies two recessions during the 1980s. However, “some smaller Gulf economies now have inflation rates of around 10%” (“The dollar | Time to break free).

In my opinion, there are two ways to respond to the problem. The first is for the Persian Gulf states to abandon their peg to the dollar and instead move to a currency basket as Kuwait has already done. A basket of securities may include the dollar in addition to the euro, yen, and other strong currencies. Thus, the inflationary pressure exerted by the dollar would be alleviated.

A second option is to all together abandon ties to any currency. This is the optimal solution that requires a strong central bank that would allow its exchange rate to float as well developed countries already do so. However, “These countries have no history of independent monetary policy and few institutions to conduct it” (“The dollar | Time to break free).

Nonetheless, the Gulf states currently have their hands tied behind their backs and are effectively linked to the dollar. Should history provide any glimpse into the future, this certainly will not change overnight.